Supply and Demand – the lost art of economics

Earlier this month the Bank of England published (http://goo.gl/sbgGJ4) a paper titled ‘The UK Productivity Puzzle’.  In summary, British productivity has not recovered post recession as it ‘normally’ does and the Bank of England appears not to know why.

Productivity is important, indeed crucial for the economy.  In the end you cannot consume more than you produce, and to get richer - by which we tend to mean to consume more per person - you have to produce more per person.  In other words productivity growth is ultimately the only way for living standards to rise.

So why has productivity failed to recover?  The paper looks at various factors in a pretty complicated way but seems to me to skirt around the most obvious reason: in economics looking at underlying supply and demand is often the easiest way to solve a problem.

Traditionally productivity has been driven up by investing capital to add machinery or equipment to make labour more efficient.  For example, at the beginning of the industrial revolution this meant applying capital to agriculture, such as the combine harvester, which meant one person could do the work of many.

This only makes sense to do if the investment cost eliminates enough expensive labour to be worthwhile.  If however the relative cost of capital and labour moves, then the cost/benefit of investing can shift discouraging organisations, both public and private sector, from applying capital.

Since the recession began this has happened, and in a dramatic way relative to previous past economic cycles.   We all know that most people are much worse off compared to 2008 – real wages on average have fallen by 6%, and by more than this at the lower skilled end of the labour force.  In other words, the supply curve has shifted to make labour much cheaper.

Meanwhile capital has become much more expensive, not simply in terms of interest rates (the typical mark up over base rate is now multiples of where it was), but also in terms of arrangement fees and more fundamentally availability of capital.  Anyone running a business or even reading the relevant press will know that bank lending has fallen sharply and many companies find it simply impossible to raise capital.  In this case the supply curve has shifted to make capital more costly or inaccessible.

With labour cheaper, and capital less available than before 2008, it is inevitable that investment has fallen and productivity stalled.  There is no mystery to the effects of supply and demand that are driving this.

Where do we go from here?  Can productivity be improved by making capital a little easier to access (but presumably not as easy as credit was available in the boom – after all too much leverage was at the heart of the crash)?  If think so, if only marginally.

But what of labour costs?  Here there appears to me to be a bigger supply and demand effect at work, one that will most probably hold back real wages for decades to come.

Last time we had a recession, back in the early 1990s, the world was a lot less global, China and India barely beginning their growth surges.  Now, for most low/medium skilled jobs there is a genuine alternative to move the work outside of the UK, maybe to the developing world, perhaps to Eastern Europe.  This means UK workers are competing with a global labour pool numbered in the billions: supply has exploded.  Even traditional professional jobs, such as research, accounting and legal work, can be placed in lower cost economies than the UK.

This surge in competition leaves relatively few such jobs in the UK (essentially only those that can’t be moved offshore like the office cleaner), and still the same number of people seeking work of that kind.  Supply flat (or even up slightly with immigration) but demand down dramatically – a dynamic guaranteed to lower pay levels.

And with billions around the world willing to do this work for less than £10 a day, the likelihood is that real wages will fall further for many in the developed world over the coming decades.  The UK is ultimately like a high priced corner shop competing with the low cost supermarkets in emerging markets.  There will only be one winner.

With labour costs unlikely to rise, capital investment will remain relatively unattractive.  Productivity is likely to stall and living standards remain flat at best.  A gloomy prospect perhaps, but one that explains the productivity puzzle.